Chris Klug
Chris is a trusted attorney with extensive experience in domestic and international taxation, corporate planning, mergers and acquisitions, and estate planning. He guides clients through complex tax matters to deliver practical solutions.
The definition of what is a small to midsize business (“SMB”) varies on who is asked and the country where the SMB is located. For the purposes of this newsletter a SMB is a business with revenues up to $100 million. It has been our experience that business owners of SMBs do not get the attention required from their professionals and are confused as to their options. We have also seen opportunities missed and significant mistakes in the tax filings for the SMB.
Importance of a Proactive and Informed Tax Advisor for SMB
It is important that the tax advisor for the SMB understands the differences in the taxation of different types of entities; is proactive in planning; proactive in projecting future growth during the life cycle of the SMB to ensure the best result and after-tax return to the owners of the SMB; and can handle the customized tax implications to the SMB.
Recently we consulted with a SMB with revenues in the $40 million range complaining that they were paying too much in taxes, they were not receiving tax advice, and their tax preparers were just inputting data into the tax return without thought. The SMB had clear goals to plan for an exit in five to seven years and get the best after-tax return to the owners during the duration of the SMB through exit.
The SMB was a pass-through entity so the tax implications of the operations of the SMB flowed through to the owners’ tax returns. The owners were concerned about their large tax bill when the cash flows did not seem to match the revenue recognized for tax purposes.
We started by reviewing the SMB’s most recent tax filing and noticed some significant errors that led to phantom income recognition. First, one of the owners repaid a $200,000 loan to the company. Repayment of principal is not subject to tax, however, on the SMB tax return a capital gain of $200,000 was reported, from which the phantom gain flowed to the owners’ individual tax returns.
A deduction of about $900,000 was entered as a negative into the SMB tax filing. This resulted in not only the legitimate deduction not being received on the SMB tax filing, but entering the $900,000 as a negative also reduced other deductions of the SMB by $900,000, the net effect is $1.8 million in additional income flowing through to the owners for the single tax year.
Planning for Optimal Tax Outcomes
We also prepared an analysis for the SMB based on keeping the SMB as a pass-through entity as compared to a c-corporation; based the analysis on certain assumptions of growth and future performance; added variations of the assumptions based on acquiring other companies and not acquiring other companies over the five to seven year period to exit; and included the tax implications of exit both at the SMB and owner level to determine the optimal tax structure for the SMB.
The analysis allowed the SMB owners to determine the best path forward with strong figures on the after-tax return. This analysis empowered the owners to make critical decisions on how to achieve the goals of the SMB.
The Need for Customized Tax Representation for SMB
It is important that the SMB receive the customized tax representation they require that is critical to the successful growth of the SMB. As the example above shows, having $2 million in phantom income erroneously flow through to the owners of the SMB causes a significant negative impact to any business and will stymie growth unnecessarily, growth that is essential to the SMB.
Further, forecasting future growth based on after-tax return is essential to empower the owners of the SMB to make the critical decisions required for the growth of the SMB. Our professionals have the experience to provide customized tax and legal representation to the SMB that is essential to their future growth.